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On Our Radar

China Opens New Front in War as Yuan Speculation Distorts Export Data

China's central bank signaled on Wednesday it was prepared to change its monetary strategy to fend off inflows of speculative capital, as Beijing struggles to control a tide of cash washing in from overseas markets.

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The move came as April exports blew past expectations, which appeared on the surface to indicate that both China's economy and global demand were on the mend. But economists were quick to suspect the figures were artificially inflated by investors who were disguising speculative bets on the yuan currency as trade payments.

Faced with the risk that such inflows could cause the yuan to appreciate so quickly that it destabilizes exports and the broader economy, the People's Bank of China (PBOC) has begun intervening heavily in the domestic currency market this year, buying up dollars and selling yuan.

This leaves the question of how to keep the yuan it has sold from distorting domestic markets.

On Wednesday morning, during a routine call to primary dealers in China's interbank market, dealers told Reuters that regulators had queried them for demand for three-month bills.

Hours later, after markets had closed, the PBOC said it would auction 10 billion yuan ($1.6 billion) of three-month bills on Thursday.

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While a relatively small amount, the central bank has not issued bills - which drain liquidity in tenors between three months and three years - since 2011. It has instead relied on short-tenor bond repurchase agreements to move money rapidly in and out of the market, much as central banks in developed economies do.

The move suggests that the PBOC is preparing to make systematic longer-term cash drains from the money supply to blunt the impact of hot money flows, with a potential knock-on impact on interest rates, market sentiment and economic growth.

The announcement came days after the country's foreign exchange regulator released new rules to crack down on inflows of hot money disguised as trade payments.

Calls to the PBOC for comment were not answered.

The last time the government made technical adjustments to its money management methods in February, domestic equity markets swooned as investors bailed out of stocks, worried that the changes heralded a wider monetary tightening that would constrict growth.

But the PBOC must balance the risk that the change will negatively impact markets against the distorting effect the inflows are having on the wider economy, in particular on exports, and by signs that capital is once again being misrouted internally into speculative channels like property instead of the real economy.

A Reuters estimate of hot money flows based on official data indicates that as much as $181 billion in speculative cash may have entered China in the first quarter, fueled in part by loose monetary policy from the United States and Europe.

And that estimate likely understates the true figure, since it doesn't account for inflows disguised as trade payments.

These inflows have helped push the yuan to new highs against the dollar on a near-daily basis, attracting even more speculation. On Wednesday, it closed at a record 6.1410 per dollar, up 1.5 percent for the year so far after rising slightly over 1 percent in 2012.

POLICY HEADACHE

While China's capital account is tightly restricted, it is not hermetically sealed, and some of the speculative inflows are conducted through legal channels.

But there are two major points of concern. One is that domestic trading companies are betting too much on further yuan appreciation, to the extent that they are borrowing the dollars they need for trade with foreign companies in order to increase their yuan stockpiles, which most economists see as unsustainable.

The other is that companies are falsifying trade transactions to get their hands on even more yuan, muddying macroeconomic indicators and embarrassing regulators.

Official data showed that April exports grew by 14.7% from a year earlier, well above expectations of 10.3 percent, but the numbers only fueled skepticism that financial maneuvering by exporters and speculative inflows are masking weakness in real demand.

Particularly suspicious were figures in both March and April showing explosive growth in exports to Hong Kong and bonded trading zones, that appeared completely disconnected from export growth to ultimate destination markets in the U.S. and Europe - and from tepid export figures for neighboring Asian economies.

Louis Kuijs and Tiffany Qiu, economists at RBS in Hong Kong, estimated that actual April export growth was only 5.7%, implying that the other 9% was actually comprised of falsified invoices created to allow trading companies to increase their yuan holdings.

However, interbank dealers who spoke to Reuters did not expect a resumption of bill issuance to panic the markets this time around, as investors are well aware of the hot money issue after repeated regulatory warnings and crackdowns.

Both equity and money markets were relatively bullish on Wednesday, and money rates eased on expectations that the central bank will actually allow more funds, not less, to flow into the market through scheduled open market operations on Thursday.

Liu Junyu, a bond and money market analyst at China Merchants Bank in Shenzhen, said that the market did not read the PBOC's move as a portent of more drastic tightening measures like interest rate hikes or increases to reserve requirement ratios at banks, both of which would make more profound and durable adjustments to base money supply that might choke off China's economic recovery.

"Given so much weak economic data and recent dubious trade data, the PBOC will probably keep monetary policy unchanged and neutral," he said.